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Add “Insurance” on Your Portfolio Using This Simple Strategy

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One of the things that separates average traders from masters is one’s ability to identify risk levels…

Really, when you dig into trading, the entire “job” boils down to risk mitigation…

But the truth is: if we do a good job containing risk, the winners will take care of themselves.

And with earnings season upon us, risk is ramping up even more.

So here’s how you can protect your portfolio in even the most risky of environment.

Get Smart and Insure Your Stocks during This Upcoming Earnings Season

Earnings announcements are the single biggest stock-moving event.

Now, you may think that companies that meet or beat expectations would be met with upside after their announcements but in reality this is not always the case.

Consider NetApp, Inc (NASD: NTAP) – this company has met or beat earnings expectations over the past eight earnings periods. You could logically expect that the NTAP would at the go up or at least not go down at earnings.

As you can see, despite meeting or beating expectations, NTAP was taken to the wood shed on its last earnings announcement dropping 11.7% overnight.

The point is that any earnings announcement, even “good” ones, can result in a significant drop in your stock.

So, the question is how do we mitigate the risk of a drop in our stocks at earnings?

The answer: insurance.

It is actually possible to buy a one-day insurance policy on our stocks to protect ourselves in the event of an adverse reaction to earnings.

I’m talking about stock options.

Options were invented to minimize risk and we can use them here to protect ourselves from stock drops, particularly gaps that occur after an earnings announcement.

Call options provide us the ability to control 100 shares of stock for a fraction of the cost, thereby reducing our investment. They make money when the underlying stock goes up.

Put options actually make money when the underlying stock drops and considered by many to be “stock insurance.”

You can buy a one-day insurance policy on a stock by buying a short-term put and holding it for one day. To minimize the cost of the insurance, use the shortest term put available.

For example, right now, 7-day NTAP At-The-Money (ATM) put options are going for $1.08 per share. With a 100-share contract size, it would cost $108 to insure 100 shares of NTAP. NTAP is currently trading at $59.43 and 100 shares would be worth $5,943.

Stated another way, $5,943 of NTAP stock can be insured for $108. If NTAP drops 10 points after earnings, the put would increase by $10/share offsetting the loss in the stock. If the stock does nothing or goes up, you’ll lose some or all of the cost of the put.

Essentially, you’re giving up $1.08 of upside in the event that the stock goes up after the announcement.